In the past, whenever the financial system came close to a breakdown, the authorities rode to the rescue and prevented it from going over the brink. That is what I expected in 2008 but that is not what happened. On Monday September 15, Lehman Brothers, the US investment bank, was allowed to go into bankruptcy without proper preparation. It was a game-changing event with catastrophic consequences.

For a start, the price of credit default swaps, a form of insurance against companies defaulting on debt, went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to “break the buck” – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.

How could Lehman have been left to go under? The responsibility lies squarely with the financial authorities, notably the Treasury and the Federal Reserve. The claim that they lacked the necessary legal powers is a lame excuse. In an emergency they could and should have done whatever was necessary to prevent the system from collapsing. That is what they have done on other occasions. The fact is, they allowed it to happen.

On a deeper level, too, credit default swaps played a critical role in Lehman’s demise. My explanation is controversial and all three steps of my argument will take the reader to unfamiliar ground.

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market. (Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.

No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.

That is what AIG, one of the most successful insurance companies in the world, failed to understand. Its business was selling insurance and, when it saw a seriously mispriced risk, it went to town insuring it, in the belief that diversifying risk reduces it. It expected to make a fortune in the long run but it was destroyed in short order.

My argument raises some interesting questions. What would have happened if the uptick rule on shorting shares had been kept, in effect, but “naked” short-selling (where the vendor has not borrowed the stock in advance) and speculating in CDS had both been outlawed? The bankruptcy of Lehman might have been avoided but what would have happened to the asset super-bubble? One can only conjecture. My guess is that the bubble would have been deflated more slowly, with less catastrophic results, but that the after-effects would have lingered longer. It would have resembled more the Japanese experience than what is happening now.

What is the proper role of shortselling? Undoubtedly it gives markets greater depth and continuity, making them more resilient, but it is not without dangers. As bear raids can be self-validating, they ought to be kept under control. If the efficient market hypothesis were valid, there would be an a priori reason for imposing no constraints. As it is, both the uptick rule and allowing short-selling only when it is covered by borrowed stock are useful pragmatic measures that seem to work well without any clear-cut theoretical justification.

What about credit default swaps? Here I take a more radical view than most people. The prevailing view is that they ought to be traded on regulated exchanges. I believe they are toxic and should be used only by prescription. They could be used to insure actual bonds but – in light of their asymmetric character – not to speculate against countries or companies.

CDS are not, however, the only synthetic financial instruments that have proved toxic. The same applies to the slicing and dicing of collateralised debt obligations and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two that have done a lot of damage. The issuance of stock is closely regulated by authorities such as the Securities and Exchange Commission; why not the issuance of derivatives and other synthetic instruments? The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.

Now that the bankruptcy of Lehman has had the same shock effect on the behaviour of consumers and businesses as the bank failures of the 1930s, the problems facing the administration of President Barack Obama are even greater than those that confronted Franklin D. Roosevelt. Total credit outstanding was 160 per cent of gross domestic product in 1929 and rose to 260 per cent in 1932; we entered the crash of 2008 at 365 per cent and the ratio is bound to rise to 500 per cent. This is without taking into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation. On the positive side, we have the experience of the 1930s and the prescriptions of John Maynard Keynes to draw on.

The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.

It can be done – by creating money to offset the contraction of credit, recapitalising the banking system and writing off or down the accumulated debt in an orderly manner. They require radical and unorthodox policy measures. For best results, the three processes should be combined.

If these measures were successful and credit started to expand, deflationary pressures would be replaced by the spectre of inflation and the authorities would have to drain the excess money supply from the economy almost as fast as they had pumped it in. There is no way to escape from a far-fromequilibrium situation – global deflation and depression – except by first inducing its opposite and then reducing it.

To prevent the US economy from sliding into a depression, Mr Obama must implement a radical and comprehensive set of policies. Alongside the welladvanced fiscal stimulus package, these should include a system-wide and compulsory recapitalisation of the banking system and a thorough overhaul of the mortgage system – reducing the cost of mortgages and foreclosures.

Energy policy could also play an important role in counteracting both depression and deflation. The American consumer can no longer act as the motor of the global economy. Alternative energy and developments that produce energy savings could serve as a new motor, but only if the price of conventional fuels is kept high enough to justify investing in those activities. That would involve putting a floor under the price of fossil fuels by imposing a price on carbon emissions and import duties on oil to keep the domestic price above, say, $70 per barrel.

Finally, the international financial system must be reformed. Far from providing a level playing field, the current system favours the countries in control of the international financial institutions, notably the US, to the detriment of nations at the periphery. The periphery countries have been subject to the market discipline dictated by the Washington consensus but the US was exempt from it.

How unfair the system is has been revealed by a crisis that originated in the US yet is doing more damage to the periphery. Assistance is needed to protect the financial systems of periphery countries, including trade finance, something that will require large contingency funds available at little notice for brief periods of time. Periphery governments will also need long-term financing to enable them to engage in counter-cyclical fiscal policies.

In addition, banking regulations need to be internationally co-ordinated. Market regulations should be global as well. National governments also need to co-ordinate their macroeconomic policies in order to avoid wide currency swings and other disruption.

This is a condensed, almost shorthand account of what needs to be done to turn the global economy around. It should give a sense of how difficult a task it is.

By Matthew Richardson and Nouriel Roubini | May 6, 2009
From the Financial Times:

Joseph Schumpeter famously argued that the essence of capitalism was creative destruction, by which new economic structures are born from the rubble of older ones. The government stress tests on the 19 largest US banks, the results of which are due be announced on Thursday, could have facilitated this process. The opportunity looks likely to be missed.The tests, which measure how viable banks are under adverse economic conditions, have no “failed” category, even if as many as 10 are reported to need additional capital. But, given that the economic environment already reflects the tests’ worst-case scenario and that recent estimates by the International Monetary Fund of financial sector losses have doubled in six months, the stress test results will not be credibly interpreted as a sign of bank health.

Instead, market participants will conclude that banks requiring extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help.

Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.

Schumpeter’s biggest fear was that creative destruction would lead capitalism to collapse from within, because society would not be able to handle the chaos. He was right to be afraid. The response of governments worldwide to the financial crisis has been to give the structure of private profit-taking an ever-growing scaffolding of socialised risk. Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?

One possible reason is the “Lehman factor” – the bank runs that would occur as a result of a big failure. But we have learnt from the Lehman collapse and know not to leave the sector high and dry when a systemic institution fails. Just being transparent about which banks clearly passed the stress tests would alleviate many of the fears.

Another reason is counterparty risk, the fear of being on the other side of a transaction with a failed bank. But unlike with Lehman, the government can stand behind any counterparty transaction. This will become easier if a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.

That leaves the creditors – depositors, short- and long-term debt-holders and preferred shareholders. For the large complex banks, about half are depositors. To avoid runs on these deposits, the government has to provide a backstop. But it is not clear it needs to cover other creditors of a bank, as the failures of IndyMac and Washington Mutual attest.

Even if systemic risk were still present, the government should protect the debt (up to some level) only of the solvent banks, not the insolvent ones. That way, the risk of the insolvent institutions would be transferred back from the public to the private sector, from the taxpayer to the creditors.

The government may be able to avoid the mess by persuading long-term creditors to swap their debt for equity, at a loss. The recent failed effort with Chrysler suggests this will not be easy. But a credible threat of bankruptcy could scare creditors into negotiation, to avoid bigger losses.

Suppose the systemic risk problem is solved. The other argument against allowing banks to fail is that after a big loss by creditors, no one would be willing to lend to banks – which would devastate credit markets. However, the creative-destructive, Schumpeterian, nature of capitalism would solve this problem. Once unsecured debtholders of insolvent banks lose, market discipline would return to the whole sector.

This discipline would force the remaining banks to change their behaviour, probably leading to their breaking themselves up. The reform of systemic risk in the financial system would be mostly organic, not requiring the heavy hand of government.

Why did creditors not prevent the banks taking excessive risks before the crisis hit? For the very same reason creditors are getting a free pass now: they expected to be bailed out. For capitalism to move forward, it is time for a little orderly creative destruction.

The asparagus, in my opinion, is closely connected to the world economy falling to its knees.

Outside San Francisco, running east, are miles of farms, with acres of these green spears. It’s a Mecca for them. The weather is perfect, sun everyday, never too hot, never too cold.

Bliss.

And the place to live is downtown ‘Frisco, close to the many world-class restaurants and funky bars that have sweeping views of the Pacific, where you can watch long rollers crashing onto the endless shore.

The year is 2003, and the economy is shaken by scandal on Wall Street. Tyco, Adelphia and Worldcom have recently imploded, Jeff Skilling is front page news, and the women of Enron are in Playboy magazine. Corporate America is in disgrace, and news of greed and swindle are rife.

But this is America, the richest nation on earth. Nothing can destroy it. Plus the fact, Greenspan in charge, and he’s a genius. Also, the Sarbanes-Oxley Act was recently introduced – a law that states the head of any corporation, along with the chief financial officer, both have to sign the quarterly financial statements from now on, stating they’re true. If they turn out to be fraudulent, they both go to jail. That should put a nice end to cooking the books.

Then Alan Greenspan decided to keep rates low… like 1% low to encourage growth. And it did. The economy was in better shape than the media thought. Yes, there’s fraud on Wall Street, but we’ll get over it. The reason for this is very simple.

One word. Two syllables. Credit. Lots of it.

Real estate suddenly became a popular commodity. People were sick of the stock market. After the dotcom bonanza, 9/11, and the crash of 2002/3, who could blame them? At least real estate is bricks and mortar, and it always goes up over ten years, and rates were low enough to get an affordable mortgage on very unaffordable homes.

So, American consumers started buying houses. People began refinancing their homes for much better rates, and before we knew it, the economy was recovering. In fact, life looked better than ever. Everyone had a BMW, and the banks were lending money so fast they looked like ticket scouts outside Fenway Park.

And then, one of the great evils was born. The shadow bank.

You’ve heard of them. Countrywide. Fremont General. New Century. Institutions specifically set-up to lend. They borrow a billion from a commercial bank, then lend it out to people who need mortgages. It’s that simple. And as a consumer, you no longer had to visit your bank for a loan, you visited a shadow bank. Because they aggressively marketed home loans. They offered rates you never imagined. They had all kinds of twists and flowery language to convince you to borrow, and buy a home. And you did. The American Dream is to own a home with a two-car garage and suddenly you had one, for a rate so low it was cheaper than renting a two-bed in the wrong part of town.

This had a positive impact on housing prices. Supply became scarce. Demand surged. Prices rocketed. Economics 101. “Mr. Jones. Will you buy this home for $500,000?” “I don’t have $500,000.” “How about zero down at 3%. That’s only $1250 a month. Do you have that?” “Yes.” “Good, then sign here.”

Housing boom. Everyone is doing it. And they are all making money. Demand drives prices. And was there ever demand!

Demand does something else. It begs for more inventory. Construction boom.

The year now is 2005, and prices in San Francisco have exploded to the upside. Locations with vistas of the Golden Gate Bridge are out of reach for most people now. But the feeding frenzy hasn’t even pretended to slow down. People are upgrading their homes across America, and California is particularly active.

Big construction outfits are building new communities in and around the San Francisco Delta, and it isn’t long before the asparagus fields are sold off to big outfits like Centex and Beazer, who erect entire communities surrounded by asparagus!

This whole bonanza pumped up the globe in a very simple loop. Rates were 1%. Banks had cheap money from the government. Lending rates for businesses were lowt, an opportunity the Shadow Banks exploited. Consumers could have lines of credit for low interest rates, especially mortgages from the Shadow Banks. New homeowners could borrow against their homes, called “home equity loans” for pennies on the dollar. With that money, they strolled off to Home Depot for DIY kits to jazz up their new homes. They bought cars, cellphones, TVs, furniture. American retail boomed.

American retail chains became cash rich. However, instead of spreading the wealth to American manufacturers, they turned to the cheapest, most efficient labor force on the planet to boost their profit margin. China, which suddenly had an unprecedented manufacturing boom. Shipping lanes come alive throughout the globe, shipping coal, oil, chemicals, steel into China, and carrying their exports to America. It’s a booming economy. The Chinese are rich, and fantasies about taking over the world start clouding their judgment. Which might be why they decided to build 20 Chicagos and exchange their bicycles for Cadillacs.

However, China couldn’t spend the money fast enough. They had trillions to spend, and there’s only one thing you can do with a trillion dollars. That’s 1000 billion, by the way. A million millions. The answer is United States Government bonds. And with this amount of money flowing into the US from China, the rates could stay low. We basically had a situation where we were borrowing wealth from China we’d created!

However, one little detail in this giant orgy of wealth had been overlooked. The whole thing was borrowed money. It was credit, created by 1% interest rates.

What if these people who couldn’t afford these homes suddenly defaulted? What about the credit card payments… those thousands of Americans balancing several cards at a time? Why wasn’t anyone afraid that this great nation was suddenly racking up debt like palettes in a shipping yard? What happens to a population, who’s levered to the hilt, living one paycheck from bankruptcy, if they catch a cold?

Armageddon happens. The world freezes. But why were the shockwaves so devastating? How did Wall Street become so involved with this madness? Why did a homeloan in an asparagus field outside San Francisco bring down Lehman Brothers and put Bank of America on life support? How did Lehman’s bankruptcy obliterate hedge funds around the world? What was the connection? What really happened at Lehman?

May 6 (Bloomberg) — The art market flunked a stress test last night as Sotheby’s posted its lowest total for a New York Impressionist and modern art auction since November 2001. The top two lots, by Picasso and Alberto Giacometti, failed to sell.

The $61.4 million total was about a quarter of the tally of a year ago and well below the auction house’s low estimate of $81.5 million. Picasso’s robin-egg blue portrait of the artist’s daughter and a bronze cat by Swiss sculptor Giacometti had each been estimated to fetch up to $24 million.

“They took a big hit in terms of credibility by not selling those two pieces,” said Andrea Crane of Gagosian Gallery. “Those estimates were way too aggressive.”

A packed crowd couldn’t mask the mood. Yawns and raised eyebrows littered the suited and Louboutin-shod spectators, as Sotheby’s had its smallest tally for the category since the $33.1 million two months after the Sept. 11 terrorist attacks.

“It wasn’t a good thing for the auction houses,” said Paul Gray of Chicago’s Richard Gray Gallery. “It will make it more difficult to attract high-end pictures.”

The Picasso was offered by William Achenbaum, a New York real-estate developer and chairman of Gansevoort Hotel Group, according to a dealer with knowledge of the collector’s holdings, who declined to be named. Achenbaum was an investor with Bernard Madoff’s $65 billion Ponzi scheme, according to a filing in the U.S. Bankruptcy Court. A call to Achenbaum’s office last week for comment on the Picasso was not returned.

‘Moving Target’

Simon Shaw, Sotheby’s head of Impressionist and modern art, said prices are “a moving target” for modern artworks. Last night’s sale total was about half the high estimate of $118.8 million.

Hours before the sale, Sotheby’s corporate credit rating was downgraded to BB-, or non-investment grade, by Standard & Poor’s Rating Services. Sotheby’s business will remain depressed for the next 12 months, Standard & Poor’s said.

Still, the auction had its highlights. Almost 81 percent of the lots found buyers, most for art priced less than $4 million. Impressionist art with lower estimates outperformed pricier modern works.

“We re-priced our classic Impressionist work and the market responded,” said Shaw.

Three Impressionist works once owned by collectors Henry and Louisine Havemeyer and lent to New York’s Metropolitan Museum drew multiple bids. Dealer David Nahmad bought Claude Monet’s 1872 French landscape with a sailboat on the Seine river for $3.5 million.

‘Back to Reality’

“Now we go back to reality,” Nahmad said. “No more speculation.”

Nahmad was the under-bidder on a black-and-white painting by the geometry-obsessed Dutch painter Piet Mondrian. The spare, 1934 “Composition in Black and White, with Double Lines,” fetched $9.3 million, cruising past a $5 million high estimate.

(Estimates do not include buyer’s premium, which is 25 percent on the first $50,000, 20 percent up to $1 million and 12 percent above $1 million.)

Tamara de Lempicka, a painter some dealers scoff at as decorative and not historically important, was another strong performer. Four de Lempicka paintings from the collection of German fashion designer Wolfgang Joop sold for a total of $13.8 million, with three ranking in the top 10 prices for the evening.

Lempicka’s portraits, dating from the 1920s and 1930s Art Deco era, are stylized images of red-lipped divas. Lempicka collectors have included performers Barbra Streisand and Madonna.

Cabaret Singer

A sultry portrait of English cabaret singer Marjorie Ferry wrapped in white toga-like drape fetched $4.9 million, an auction record for the artist.

Last year, Sotheby’s and Christie’s International announced they were phasing out the practice of guaranteeing a seller a minimum price regardless of a sale’s outcome, to improve profitability.

Sotheby’s Chief Executive Officer William Ruprecht said at the auction it was the company’s most profitable Impressionist sale in 12 months.

“There’s a lot more coming in than going out,” he said. He declined to comment about the credit downgrade.

“I think the market is very strong for a recession,” said John Bloomberg, a Park City, Utah-based skier and former hedge fund manager, who bid unsuccessfully for several Impressionist pieces. Bloomberg is no relation to Michael Bloomberg, the majority owner of Bloomberg LP.

Contemporary Test

Christie’s offers about 50 lots tonight, estimated to fetch between $94.9 million and $134.6 million. Both auction houses face a bigger test next week when they sell contemporary and postwar art, the category that underpinned the boom of the last five years.

The slumping market and absence of guarantees meant owners were less willing to part with top-notch goods.

The unsold Picasso last night was a squat 1938 portrait of the artist’s two-year-old blond daughter, Maya, the offspring of a liaison with his mistress Marie-Therese Walter. A clue to the failure: Sotheby’s condition report revealed the canvas had a patched hole. Also, the painting has awkward proportions, paring a child’s body and an adult’s face.

THE eagerly awaited Wall Street exposé . Written by a perfect combination of authors. By Lawrence G McDonald, the hard-driving Lehman Brothers trading Vice President, and the #1 New York Times bestselling author Patrick Robinson, the man who wrote Lone Survivor for the Navy SEAL Marcus Luttrell.

Direct from the heart of Lehman Brothers, the bank that smashed the world’s economy. An incredible blow-the-lid-off account of the greed, the misjudgements, the dreadful stupidity of men who should have known better. Revealed by a man who was there, the eyewitness, Larry McDonald. Anyone, laymen or expert, can understand the crucible of a Wall Street trading floor. This is a black box of secrets. And now Larry McDonald rips the lid off.

It was 1967 when a New Bedford textile corporation in Massachusetts, suddenly upped and purchased National Indemnity, a substantial insurance operation out of Omaha, Nebraska. The textile mill was Berkshire Hathaway, and its owner, Mr. Warren Buffett stumped up $8.6 million, which was a sizeable amount of money in 1967, perhaps close to $100 million.

At the time, there were financial journals in the USA which considered, quite frankly, that the sage of Omaha may have temporarily lost his grip, any kind of connection between the East coast fabric outfit and the Midwest underwriters being strictly coincidental.

They learned, however, the danger of trying to outthink Mr. Buffett, who as usual ignored them totally, said nothing and went right ahead with what he believed made sense. He was guided by one star which glimmered above the old New England mill town, casting its cold light on the remnants of another industry which had once died in New Bedford, whaling.

Because not so far from those ancient jetties, just a couple of streets back from the water, Berkshire Hathaway was eating up cash faster than a whaling fleet in barren seas. Warren needed to pump up that Berkshire cash-flow and he searched for a business which generated money, earned it before it needed to spend.

Insurance was the answer he arrived at, because those financial institutions collect the premiums, and do not pay out claims for many weeks, maybe months. He was without doubt the first person on earth to understand the concept of ‘float’ – that’s the cash which is sitting in the bank accounts of insurance companies, the capital they may need for a big claim. But it’s still just sitting there, and Warren Buffett decided he could definitely put that cash to work, over 1,400 miles to the east, on the cold shores of Massachusetts where Berkshire Hathaway needed new investment in weaving looms, plant and equipment.

Warren had no plans to run an insurance company. He just wanted their ‘float,’ just the money. He considered it to be ‘rocket fuel,’ like sending a pipeline into a river of money, which would lift his textile company higher. Not just with its own looms, but to enable it to buy other businesses, newspapers, even a bank, on the back of the cash stream from National Indemnity.

Letting Lehman Brothers collapse was a huge mistake, according to many people who worked on Wall Street during the economic crisis of 2008. They think it was a conspiracy between Hank Paulson, Geithner, Bernanke and the chiefs at Bank of America and JP Morgan.

But this isn’t really true. It wasn’t a conspiracy to let Lehman Brothers go bankrupt. It was actually a little more personal than that. It was simply a question of two men not really liking each other. Hank Paulson and Dick Fuld had not been friends for a long time. That “huge brand” dinner, April ’08 marked the beginning of the end for Lehman Brothers. Paulson wouldn’t save Dick Fuld. No. He thought Dick should hit a bid and stay out of the Fed window.

But Fuld didn’t. The rest is history, and it’s all in my new book. Every last detail.